Trustees and Beneficiaries Beware: Think Twice Before Modifying an Irrevocable Trust

By: Christina M. Chan

Estimated reading time: 6 minutes

Under section 6110(i)(1) of the Internal Revenue Code, a Chief Counsel Advice memorandum (“CCA”) is a term used to describe written advice or instruction issued by the Service or the Office of Chief Counsel to field offices concerning the IRS’ legal interpretations or positions on existing or former revenue provisions. While CCAs do not have precedential value, they are required to be released to the public for the purpose of providing taxpayers with the views of personnel of the Office of Chief Counsel as to current tax issues.

On December 29, 2023, the IRS National Office issued CCA 202352018, in which the IRS took the position that the trustee’s modification of an irrevocable grantor trust (with the consent of the beneficiaries) to add a tax reimbursement clause constituted a taxable gift by the trust beneficiaries to the grantor. The IRS reasoned that because the original trust instrument was subsequently modified to add a clause which gave the trustee the power to make discretionary distributions to the grantor to reimburse the grantor for taxes paid by the grantor on the trust’s income (“tax reimbursement power”), this constituted a relinquishment of a portion of the beneficiaries’ interest in the trust to the grantor.

Background

An intentionally defective grantor trust (“IDGT”) is an irrevocable trust created by an individual (the “grantor”) during their lifetime. The grantor may fund the IDGT by selling or gifting assets to the trust by utilizing their available lifetime estate and gift tax exemption (currently $13,610,000 per taxpayer for 2024). As a result, any such assets transferred to the IDGT will be removed from the grantor’s estate for federal estate and gift-tax purposes. However, the trust is “defective” for income tax purposes – which means that the grantor (and not the trust) remains responsible for paying any income taxes generated by the trust’s earnings.

An IDGT is a powerful estate planning tool because (1) the value of the trust’s assets can continue to appreciate outside of the grantor’s taxable estate, and (2) the grantor can further reduce their taxable estate by paying the income taxes on the trust’s earnings without gift tax consequences to the grantor. Consequently, an IDGT allows the grantor to reduce the size of their taxable estate in a highly efficient manner.

However, if the trust’s assets generate substantial taxable income, this could create an economic hardship for the grantor (who must shoulder the trust’s tax burden). To address this issue, some practitioners have recommended modifying the trust to grant the independent trustee the discretionary power to reimburse the grantor for any such income tax payments. Previously, in PLR 201647001, the IRS took the position that the modification of a trust to add a discretionary trustee power to reimburse the grantor for the income tax paid attributable to the trust income is administrative in nature and does not result in a change of beneficial interests in the trust. However, CCA 202352018 explicitly overrules the position previously taken by the IRS in PLR 201647001.

Facts

In the case at issue in CCA 202352018, a parent established an irrevocable grantor trust for the benefit of the grantor’s children and descendants. The grantor was not a beneficiary of the trust, and neither state law nor the governing trust instrument provided the independent trustee with a mandatory or discretionary tax reimbursement power.

The trustee subsequently petitioned the State court to modify the terms of the trust to provide the independent trustee with a discretionary tax reimbursement power. Pursuant to state statute, the beneficiaries consented to the modification. The state court granted the trustee’s petition and issued an order modifying the trust to provide the trust with a discretionary tax reimbursement power.

Analysis of Gift Tax Consequences

In Rev. Rul. 2004-64, the grantor created an irrevocable grantor trust for the benefit of grantor’s descendants. The ruling concluded that where the original trust instrument contained either a mandatory or a discretionary tax reimbursement power, the trustee’s exercise of such power would not be treated as a taxable gift by the trust beneficiaries because it was either mandated by the terms of the governing instrument or made pursuant to the exercise of the trustee’s discretionary authority granted under the terms of the governing instrument.

However, CCA 202352018 distinguishes Rev. Rul. 2004-64, stating that where a trust is subsequently modified to add the tax reimbursement power, the trustee’s exercise of such power constitutes a taxable gift by the beneficiaries because the beneficiaries have parted with some portion of their interest in the trust and the grantor has acceded to that interest. The CCA also concedes that significant practical challenges may occur in valuing the gift(s).

Significantly, CCA 202352018 implies that the beneficiaries’ consent to the modification is not determinative to whether the addition of a tax reimbursement clause constitutes a taxable gift by the beneficiaries, given that the “result would be the same if the modification was pursuant to a state statute that provides beneficiaries with a right to notice and a right to object to the modification and a beneficiary fails to exercise their right to object.” Ostensibly, this would appear to encompass a decanting or other proceeding pursuant to state law that gives a beneficiary notice. However, notably absent from the IRS’ analysis is whether a beneficiary who objects to a modification yet fails to prevent the modification from happening should be deemed as having made a taxable gift.

Conclusion

CCA 202352018 has triggered many questions about how the ruling might be applied. In the case at issue, no guidance is offered about how to value the interest relinquished by the beneficiaries or how it may be allocated amongst multiple beneficiaries. Moreover, while CCA 202352018 only addresses the scenario where the beneficiaries consented to a trust modification which gave the trustee a discretionary tax reimbursement power, the IRS could take the same position with respect to any modification that changes a beneficiary’s interest in trust. Indeed, the IRS has taken this approach before, as evidenced by Private Letter Ruling 200917004 (Apr. 4, 2009) (where trust beneficiaries’ consent to a trustee’s petition to modify trust to expand definition of “issue” and “descendants” to include legally adopted issue resulted in a taxable gift by the consenting trust beneficiaries); as well as Private Letter Ruling 9308032 (Nov. 30, 1992) (where trust beneficiaries’ written agreement to alter the term “descendants” to include adopted children was deemed a taxable transfer by the consenting trust beneficiaries).

Ultimately, the changes proposed by a modification and how the beneficiaries may be affected by such changes should be carefully considered before proceeding. Therefore, the following alternatives should be considered in lieu of modifying an irrevocable trust to add a tax reimbursement power:

1. Toggling off grantor trust status (which would cause the trust to be taxed as a non-grantor trust, meaning that the trust would be treated as a separate taxpayer for federal income tax purposes);
2. Loaning funds to the grantor; and
3. Using powers of substitution (i.e. “swap powers”) to exchange illiquid assets owned by the grantor for cash of equal value.

© The Regents of the University of California, 2024.

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